Reducing Debt, Good or Bad?

The conventional wisdom is that encouraging people to reduce debt is good. Well normally that is true, but at the moment it could actually be bad! Believe it or not, people focusing on reducing their debt levels could actually make the world's economic outlook even worse according to some just released research from the McKinsey Global Institute (MGI).

As they point out, the US consumer's seven year long spending spree has come to an end and the consequences are having a major impact on the US economy. But as usual, it does not end there because whether we like it or not, it is still true that the US economy can have a massive impact upon people all over the globe, even in remote villages. As a result, the behaviour of the US consumer is significant because of the flow on effect.

Remember chaos theory and the butterfly flapping it wings in Brazil causing a cyclone in Texas, well it is a little like that.

You only need to look at what happened between 2000 & 2007 to get an idea of just how important US consumption was/is. During that time US households dramatically increased their borrowing, virtually doubling their debt to almost US$14 trillion (yes, trillion as in thousand billion). This increase in debt grew faster than their incomes and even the GDP of the country. According to MGI the level of US household debt represented 98% of the GDP of the entire US, or put another way, 138% of disposable income.

Any fall in US consumption is significant as US consumers have accounted for more than three quarters of US GDP growth since 2000 and for more than one third of global growth in private consumption since 1990. These trends were fueled by several factors, not least of which was the surge in household debt, particularly after 2000. This coincided with a decline in the US personal savings rate. Americans joined Australians by having a negative savings rate in 2005.

What all this meant was that in the 7 years between 2000 & 2007, US household debt grew as much, relative to income, as it had during the previous 25 years.

That all changed in 2008 as for the first time since the 1940s, US households reduced their outstanding debt. The consequences have been staggering because as they reduced their debt, consumption slumped. As I mentioned above, this has had all sorts of flow on effects around the world.

As we all know, rapidly appreciating household assets enabled consumers to spend and borrow more even as they saved less. The value of US household assets rose by some $27 trillion from 2000 through 2007. Rising home values, as well as share portfolios and other financial assets, accounted for more than two-thirds of this gain. What happened was that US consumers (amongst others) simply used their houses as virtual ATMs.

Between 2003 & 2008, US households took more than US$2 trillion out of their homes by increased loans and refinancing. According to the analysis conducted by MGI, approximately US$900 billion was used for home improvement and/or personal consumption. To put that figure in context, that is more than President Obama's recent huge stimulus package!

That still leaves more than a US$ trillion unaccounted for. So what happened to the rest? Apparently some of it was used to pay of debt.

But, you may ask yourself, how can this be as debt increased during this period?

Quite simple. They paid this money off their credit cards and promptly borrowed even more, thereby fueling still more economic activity.

But wait, there's more.

Of course, not all the money was actually 'spent'; some was invested, which as we all know helped fuel stock market gains. That in turn led to yet more borrowing leading to yet more spending etc. etc.

It was inevitable that at some point things had to stop. As they say hindsight is a wonderful thing.

So that explains the move upwards but does not really explain some the problems we are now having and why reversing the trend of the last 7 years is actually making things worse.

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